Chapter 11: Cash Flow Forecasting
what are the three degrees of certainty as applied to cash flows
**Another way to aggregate cash flows is based on a given cash flow's degree of certainty, as described below. ++Known cash flows --The timing and amounts of certain cash flows are fixed and known in advance. >>Common examples include interest expense, principal repayments, dividends, royalties, rent, and tax payments. ++Predictable flows -- Cash collections from credit sales are an example of a cash flow component that can be predicted with reasonable accuracy. The cash flow on a given day depends on factors such as the level and pattern of past sales, age of accounts, number of customers, and payment histories. For certain firms, these factors enable reasonably accurate cash flow prediction. Disbursement for payroll and benefits tends to be very predictable because it is based on the number of employees, compensation method, and historical experience. Similarly, vendor check-clearing patterns can be predicted based on experience with clearing times. ++Less predictable cash flows -- Some cash flows are difficult to forecast. <<Examples include cash flows related to sales of a new product, unexpected repairs, or pending settlement of insurance claims. Less predictable cash flows also include the timing of marketing costs, travel, and bonuses. Collaboration with other functional areas of the organization may reduce the uncertainty associated with these cash flows. The experience and judgment of the forecaster are important in such situations.
what is a distribution forecast
++A distribution forecast uses historical patterns to allocate proportions of total cash flow over a time period. >>For example, a retail store may have projected sales of $1,000,000 for a one-month period. Historical patterns indicate that in an average month, 20% of sales occur in the first week, 40% of sales occur in the second week, 30% of sales occur in the third week, and the remaining 10% of sales occur in the fourth week. This pattern may be used to forecast weekly sales of $200,000 in week one, $400,000 in week two, $300,000 in week three, and $100,000 in week four. The method is used widely for short-term forecasts. ++Distribution percentages are commonly calculated with simple averages and regression analysis.
strategic planning or FP&A functions typically use what kind of forecasts
++Medium- and long-term forecasting involves the development of pro forma financial statements. Such forecasts are typically used in strategic planning or FP&A functions. ++Coordinating collection of the required data and verifying the variable assumptions is important. The availability of internal accounting data provided by ERP or integrated accounting and reporting systems makes this task significantly easier. Many of the advanced reporting systems have sophisticated forecasting models as one of their options.
what is a receipts and disbursements forecast
++Projecting receipts and disbursements is the core of short-term cash flow forecasting. This forecast begins with separate schedules for cash receipts and disbursements. ++The schedules are prepared on a cash basis, rather than on an accrual basis, due to the need to forecast cash rather than earnings; this is especially important for firms with high levels of A/R and A/P. A good place to start is with the historic information provided in bank account statements, which by their nature are cash statements.
what are the statistical methods of forecasting
++Statistical methods are used for both short-term and long-term forecasting. ++There are many statistical approaches that are available for cash flow forecasting purposes. One of the most general statistical methods is that of time-series methods or extrapolation, where past trends are identified and used to predict the pattern of future cash flows. Simple moving averages and exponential smoothing are two of the most common applications of time series forecasting techniques. Other popular statistical techniques include correlation and regression analysis.
what is an A/R balance pattern
++The A/R balance pattern may be used to forecast collections from credit sales. ++An A/R balance pattern specifies the percentage of credit sales during a time period (e.g., one month) that remain outstanding at the end of the current and subsequent time periods. ++The A/R balance pattern is used to determine a collection pattern that is used to forecast cash inflows. ++An average percentage collected during a given month is calculated by subtracting the percentage outstanding at the end of the month from the percentage outstanding at the beginning of t
what is the goal of cash forecasting
++The goal of cash flow forecasting is to optimize future cash resources. ++Cash flow forecasting assists a treasury professional in planning cash management activities, such as scheduling cash concentration transfers for field and collection accounts, funding disbursement accounts, making short-term investing and borrowing decisions, and establishing and managing target balances for purposes of bank compensation, covenant management, and regulatory requirements. ++Despite its importance, cash flow forecasting remains an inexact science. This is attributable to the number of assumptions that must be made to forecast cash. For this reason, the assumptions underlying the cash forecast should be reviewed and updated frequently with the most current and complete information available
what are the key steps in selecting a forecasting method
++The process of selecting a method of forecasting involves several key steps. ++These include establishing data relationships, selecting a method, testing and validating relationships, using technology.
for what tasks is an accurate cash forecast essential
--The accurate prediction of cash inflows and outflows over time is an important part of a treasury professional's job and is essential to a variety of tasks: ++Managing liquidity -- Forecasting the net cash position at different intervals to identify potential cash excesses or shortages is essential for scheduling investment decisions and anticipating borrowing requirements to meet daily obligations. Liquidity management is the most important motive for cash flow forecasting. ++Maximizing returns -- A cash forecast provides the timing and amounts of anticipated cash surpluses and cash deficits. Short-term investment returns are maximized when treasury professionals have time to select optimal investment instruments and maturities. If the firm follows a matching strategy for short-term investments, the maturity of an investment will be matched with the timing of future cash deficits. Knowing that the firm does not expect a cash deficit for a certain period of time allows the treasury professional to extend investment maturities and earn higher yields. ++Controlling financial activities -- Variance analysis that compares actual cash flows with projected cash flows can help identify problems such as unanticipated inventory changes, delays in A/R collection, the mistiming of payments, and fraud or embezzlement. Early identification signals management to initiate corrective measures. ++Meeting strategic objectives -- Cash forecasts are used to project future funding requirements and make operating decisions to support the strategic plan. ++Budgeting capital -- Forecasts of revenue, expenditures, and funding are not only helpful for developing cash forecasts, but are also needed for the evaluation of capital investment alternatives (i.e., capital budgeting). ++Managing costs -- Cash forecasts can help minimize excess bank balances, reduce short-term borrowing costs, and increase short-term investment income. ++Managing currency exposure -- Cash forecasts attributable to foreign operations are used to assess the degree of foreign currency exposure and provide information for policies designed to control currency risk. ++Compliance requirements -- Cash forecasts are frequently part of internal control procedures needed to comply with loan covenants, meet minimum capital requirements, or requirements for imprest tax accounts. This is especially important for publicly traded companies.
what are the three steps required by the percentage of sales method
--The percentage-of-sales method requires three steps: 1. Forecast the income statement and balance sheet based on the relationships mentioned previously. (See Exhibits 14.5A and 14.5B.) 2. Calculate the projected ending cash balance by determining how the forecasted income statement and balance sheet values impact cash (i.e., utilize a cash flow statement given the impact of changes to investments, capital/depreciation, and potential slowing of cash collections or payments). (See Exhibit 14.5C.) 3. Compare the projected ending cash balance with the firm's target cash balance, and adjust the pro forma statement to show the source of funding for a cash shortfall or the investment of a cash surplus. (See the note at the foot of Exhibit 14.5C.)
what are the two major categories of cash forecasts
>>Forecasts serve a variety of purposes, from making short-term investing and borrowing decisions to strategic decisions about projects and long-term investments and their subsequent funding. Whatever the actual purpose, forecasts can be broken down into two major categories: ++Predictive forecasts attempt to predict or project what will happen in the future. They can be used to answer questions such as "How much cash will I have available to invest over the next week?" or "Will I need to borrow money against my line of credit in the next week?" ++Analytical forecasts also referred to as simulations, are used to answer what-if questions or to predict the financial impact of a given action. They are particularly useful in strategic planning around things like capital investments or tax planning.
what factors should be considered in identifying cash flow data
>>Identifying suitable data is an important part of the cash flow forecasting process. The following factors should be considered: ++Available information -- Information may be gathered externally or internally. Sources include the firm's banks, field managers, sales managers, and the A/P, A/R, payroll, FP&A, and tax departments. In many cases much of this data is available from internal systems, such as general ledger (G/L) systems, enterprise resource planning (ERP) systems, or treasury management systems (TMS). ++Assumptions -- It is important to understand the assumptions underlying the various projected input data to determine how accurate and useful it may be. If sales managers are assuming that all accounts will be paid on time while the overall economy is slowing down, the treasury professional may need to adjust the underlying assumption to get an accurate cash forecast. Cash flows should be discussed with key participants to gain insight into any issues or quirks that need to be included in the forecast. For example, it may be important to know whether specific payments are made monthly, quarterly, or annually. For example, retailers might expect that 80% of their projected annual sales occur in the last two months of the year. ++Desired type of forecast -- The data collected should be dictated by the desired cash forecast, not simply by the data that is available. For example, if preparing a short-term cash needs forecast, immediate A/P data may be important, but long-term capital acquisitions and planned securities offerings are probably not needed. ++Source of information -- Source identification is affected by the degree of centralization in the firm's cash management structure. In a decentralized firm, field managers usually have the most current financial data related to their operations. However, a centralized firm is often less dependent on numerous field sources. ++Bank account structure -- Bank account structure is also important in that it may help group cash flows in a meaningful fashion and help identify potential changes. For example, using a concentration account to collect cash inflows and disburse cash outflows via ZBAs helps to facilitate cash flow forecasting compared to a system of multiple, stand-alone accounts. ++Reporting requirements -- To ensure the usefulness of the data selected, it is essential that the data are defined precisely and reported accurately in a timely manner. This should include an analysis of variances between the forecast and actual results to help track accuracy and improve future forecasts. A growing number of firms use company intranets, dashboards, and treasury websites to distribute management reports and cash forecasts. ++Historical data -- A variety of data from prior periods are useful in predicting the amount and timing of cash inflows and outflows. Credit sales, payment histories, purchases, and scheduled payments are examples. Historical data is used to analyze trends and seasonality in the firm's cash flows.
what is the forecast frequency
>>The frequency and type of update are also important factors to consider when working with cash forecasts: ++Static forecasts -- As the name implies, a static forecast is one in which the time period of the forecast does not change but remains static even though the actual numbers or data in the forecast change over time. The period of time used in the forecast remains constant, and the forecast is updated at the end of the forecast period to show the next period. A monthly (or quarterly) cash forecast that is done each month (or quarter) is an example of a static forecast. An annual budget is another common example of a static forecast in that the budget, which is a type of forecast, is normally always for the same 12-month period (e.g., January through December), even if the numbers are updated during the year. ++Rolling forecasts -- In contrast to a static forecast, a rolling forecast has a constant number of periods (weeks, months, etc.) and is updated on a regular basis. That is, this type of forecast "rolls" forward. An example of a rolling forecast would be a 13-month cash forecast that is updated monthly. Assume that the initial forecast covers the 13 months from January 2xx1 through January 2xx2. Sometime during January 2xx1, the forecast will be updated and will now cover the 13 months from February 2xx1 through February 2xx2. If nothing has changed, then January 2xx1 is dropped from the forecast and the projection for February 2xx2 is added. In reality, the forecast data for the other months in the report are typically also updated because newer information is now available.
what are the three forecast horizons
>>The time interval over which information is to be forecasted is an important consideration because a method appropriate for a short-term forecast will not be appropriate for longer term forecasts, and vice versa. In most companies, short-term forecasting is the responsibility of treasury while longer term forecasts are often done by FP&A or the capital budgeting unit. ++Short-term forecasting -- Short-term forecasts typically range from one to 90 days in length and predict cash receipts and disbursements, as well as the resulting balances, on a daily, weekly, monthly, or quarterly basis. They aid in scheduling cash transfers, funding disbursement accounts, and making short-term investing and borrowing decisions. Short-term forecasting is also important for establishing and managing target balances for purposes of bank compensation. To reduce potential overdrafts and other related bank fees, some firms create intraday cash forecasts. This practice is supported by the availability of intraday balance reporting data that is provided by many banks. ++Medium-term forecasting -- Cash forecasts from three to 12 months in length are an integral part of cash budgeting and are considered medium-term forecasts. These forecasts project the inflows (e.g., collections from sales and other sources of funds) and outflows (e.g., expenses and other uses of funds) on a monthly or quarterly basis. Medium-term forecasts are used to determine the firm's need for short-term credit or the availability of excess cash for short-term investing. They also serve as a benchmark for performance by comparing actual cash flows to projected cash flows based on the cash budget. ++Long-term forecasting -- Long-term forecasts cover any period beyond one year. These forecasts take into consideration projections of long-term sales and expenditures, as well as market factors. Long-term forecasts are of strategic importance because they help inform decisions about which type and amount of long-term financing to obtain, and the timing of obtaining funds. Financial institutions and rating agencies also use long-term forecasts for credit analysis and evaluation purposes.
what four steps are essential to cash forecasting
Cash flow forecasting requires a treasury professional to take four essential steps: 1. Establish assumptions. 2. & 3. ? Estimate future cash inflows and outflows. 4. Generate a pro forma cash position.
